Our most recent quarterly client letter outlined the debt ceiling debate and examined the current and projected state of the U.S. national debt. We now will explore further the potential impact of government deficits (annual spending exceeding revenues) and debt (accumulation of borrowing to fund annual deficits) on financial market returns.
As government spending hits record levels around the globe, some politicians, economists and market pundits are warning that rising indebtedness may drag down economies and financial markets. This issue has raised concern among investors who assume that a government’s fiscal policy is closely linked to the country’s economic growth and market returns.
The graph below shows the projected state of indebtedness around the world.1 Over half the Organization of Economic Co-operation and Development (OECD) member countries expect to have debt-to-GDP (gross domestic product – a measure of aggregate national output of goods and services) levels above 70%—and the U.S., Canada and the U.K. project debt levels exceeding 80% of their economic output.
Government efforts to stimulate these economies out of recession may partly explain this level of borrowing, which is high compared to historical levels. But longer-term trends such as aging populations, expanding public pensions and rising health care obligations are compounding the fiscal challenges of these countries.
So how does public debt affect economic growth and market returns? The evidence might surprise you. Although rising levels of government debt create headwinds for economic growth, a country’s deficit and debt levels do not seem to adversely impact capital market returns.
Let’s explore these issues by addressing a few questions about government debt.
Do rising deficits drive up interest rates?
Yes. As borrowing increases, a government must pay higher interest rates on its debt to attract investors. The government is effectively competing for capital that could otherwise be invested in the private sector—a displacement of resources known as the “crowding out effect” in economic theory. Additionally, as debt levels rise, market concerns about higher default and inflation risks put additional upward pressure on interest rates.
Consistent with this theory, analysis shows that current interest rates reflect expectations of future deficits2 but that current government deficits and debt do not predict future interest rates or bond returns.3 So, long-term interest rates rise when the market expects future deficits to increase. However, today’s interest rates and bond prices already reflect information about current government spending, and markets quickly incorporate new information.
Do higher deficits hamper economic growth?
It depends on a country’s debt level. Using World Bank data from 1991 to 2008, comparing current deficits to future GDP growth in sixty-seven countries indicated an increasing interactive effect between deficits, debt and economic growth. High-debt countries that run deficits are more likely to experience lower economic growth over the next three years. But numerous forces may affect a country’s economic direction, and deficits explain only a small fraction of the variation in future GDP growth. The combination of high debt and deficits can create headwinds for economic expansion, but slower growth is not guaranteed.
So investors are justified in having some economic concern about higher government spending and borrowing. However, the impact on investment returns is less clear. Let’s now consider the potential effect on equity markets.
Does low economic growth result in diminished equity returns?
No. This relationship can be tested by comparing a country’s GDP growth to its equity market performance in subsequent years. To conduct the analysis, the world’s developed market countries were divided each year into high-growth and low-growth “portfolios” based on growth in real GDP. There was no statistical difference between the annual returns of equity markets in high-growth versus low-growth countries. In fact, low-growth countries had slightly higher average returns than high-growth countries.
The graph below illustrates this relationship in terms of a dollar invested in high- versus low-GDP growth portfolios from 1971 to 2008. The low-GDP growth portfolio’s higher annual return would have generated slightly more wealth for the period. The chart details the average annual return and real GDP growth for both groups.
Applying the same methodology to emerging market countries shows an even greater return difference, although the data period is much shorter (2001 to 2008). The return of the high-growth country portfolio averaged 19.77% (with 2.5% GDP growth), versus 24.62% for the low-growth portfolio (-4.94% GDP growth).
Other research has confirmed a weak relationship between a country’s economic growth and its stock market returns.4 Several factors may contribute to this decoupling effect. For one, with globalization, a multinational company’s stock price in its home market may not reflect economic conditions in other countries. Also, the fruits of economic growth do not accrue exclusively to shareholders of public companies, but also to income earners and private businesses.
Finally, consider that risk, not economic growth, determines a stock’s expected return. Research indicates that this principle also applies to a country’s stock market.5 Similar to value and growth stocks, markets with a low aggregate price relative to aggregate earnings (or book value) have high expected returns, and markets with a higher relative price have lower expected returns. Consequently, while holding a “growth market” may be a rational investment approach, investors should not expect to earn higher returns by tilting their portfolios toward countries with high expected GDP growth.
Do fiscal deficits lead to currency depreciation?
No. It is commonly believed that large fiscal deficits and high debt cause a currency to depreciate as the government borrows more from foreign sources, and investors who are concerned about inflation and default risk flee the currency. Although recent developments in the U.S. would seem to support this relationship, there is less convincing long-term evidence that deficits affect currency rates. During the 1970s and 1980s, the dollar strengthened while the government increased deficit spending. This observation is consistent with academic studies concluding that exchange rates appear to move randomly, and there are no models to date that can reliably forecast currency returns.6
Some economists claim that developed market countries are moving into an era of high government deficits and lower market returns. While higher deficits and debt may impact a nation’s interest rates and economic growth to some extent, the investment implications are not easily discerned. History does not offer strong evidence that current deficits predict future bond or equity returns in a country’s financial markets, or anticipate short-term currency movements.
Investors should assume that stock and bond prices reflect all that is currently known and expected about government spending and debt, economic growth, risk and other issues affecting performance.
1. The Organization of Economic Co-operation and Development (OECD) is an international economic organization of thirty-three countries founded in 1961 to stimulate economic progress and world trade. Its government debt figures are inclusive of intragovernmental debt (money the federal government owes, and pays interest on, to itself).
2. Today’s interest rates reflect expectations of future deficit levels. The analysis compared five-year U.S. deficit projections (as a percent of GDP) to yield spreads (five-year U.S. Treasuries minus three-month U.S. Treasuries) from 1992 to 2010. The yield spread increased 29 basis points for every one percentage-point increase in projected deficits. Data sources: Baseline projected deficits from the Congressional Budget Office; yields from Federal Reserve Bank of St. Louis.
3. Today’s deficits do not predict tomorrow’s interest rates or bond returns. Regression results show that current deficits do not reliably predict changes in the five-year U.S. Treasury yield spread (1982 to 2009) or future bond returns (1947 to 2009). Data source: Federal Reserve Bank of St. Louis.
4. MSCI Barra Research Bulletin, “Is There a Link Between GDP Growth and Equity Returns?” May 2010.
5. Clifford S. Assness, John M. Liew, and Ross L. Stevens, “Parallels between the Cross-Sectional Predictability of Stock and Country Returns,” Journal of Business 79, no. 1 (March 1996): 429–451. Their research uncovered strong parallels between the explanatory power of aggregate book-to-market and aggregate earnings-to-price ratios for country stock markets.
6. Richard A. Meese and Kenneth Rogoff, “Empirical exchange rate models of the seventies: Do they fit out of sample?” Journal of International Economics 14, no. 1 (February 1983): 3–24. Kenneth Rogoff and Vania Stavrakeva, “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting” (National Bureau of Economic Research working paper No. 14071, June 2008).